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The most important concept in finance

I was going to write a blog about why I think China looks more like developing Japan (with the same dreadful destination) than developing America, but realized I just couldn’t get there without an intermediate step.

That intervening step may seem like a minor point, but I believe it’s the most important concept in finance and one of the most important in economics: return on capital.

Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!

Return on capital probably seems like either a very mundane or overly abstract concept. Everyone knows that for any financing to work, the financier must get his capital back and then some. Otherwise, why bother, right?

But, it seems like people frequently drop this context when they discuss broader issues.

Take college loans for example. If you lend someone more money than they could possibly repay to go to college, it’s not economic. But, you’ve got to do the math to really grasp this concept.

If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate–and that’s without paying any of the principal!

No intelligent financier would ever make such a loan, yet most people think the financier is being mean. What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier–such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy. It’s not mean, it’s just a plain stupid.

In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions. I hope that 2007-2009 has convinced most people of the soundness of this logic. If you can’t get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved. If you can’t get a positive return on capital, it’s not financial or economic, it’s charity.

Society does not grow and prosper by charity, it requires a positive return on capital. For those who wish we were ants or that reality was other than it is, this may be a real downer, but that’s the way it is.

In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.

What, exactly, does that term mean, anyway? It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time. Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest.

Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you’re wasting your time and someone else’s money.

Or, even more fundamentally, if you don’t produce something worth more than $10, then you’ve reduced the productive capital available and thus lowered everyone’s standard of living (please see Peter Schiff’s How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).

This is not a minor point, I hope you can see. If you lend someone $10 and they can only pay back $9, it’s not just bad for you, it’s bad for them and for the rest of society. Those 10 dollars were earned by your time, effort and resources, which you can never get back. That $1 is done, gone, kaput!

Perhaps dollars is an inadequately concrete way to describe this point. Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service. Nothing you can do will bring that piece of wood back. That wood can’t be used for fuel, or be turned into furniture, or anything else ever again. Time and effort would have to be expended to gain a new piece of wood–time and effort could have been used productively instead of simply bringing things back to the way they were before.

Return on capital isn’t just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living. We must use our resources wisely such that they produce more and more each year.

It’s the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.